Russian Oil Supply: Uncertainties and Incentives

Russian Oil Supply: Uncertainties and Incentives Yuri Yegorov 1 January 2016 Task (FWF). Oil peak now attracts more attention of energy economists (see, for example, Semmler and Greiner, 2011). An uncertainty of future oil peak plays an important role for the incentives to do fast transition to alternative fuels, especially those replacing oil. But what factors are essential in this uncertainty? One of them is related to future oil supply of Russia. If one trusts the statistics provided by BP, Russia has only a tiny fraction of world oil deposits (about 6-7%), and thus cannot keep parity in oil production with substantially more oil endowed Saudi Arabia for long time. But if it has more oil (let say, 10-13%, as Russia claims in some sources; see, for example, Simonov, 2006), then Russia can maintain such supply not for 2, but for 3 or 4 decades. Here, however, we have an incentive problem. Would it be optimal for Russia to keep production parity with Saudi Arabia, it then it will be fully stripped of oil reserves earlier, when future oil price is likely to be higher. Here we have well known dynamic optimization problem of optimal path for cake eating for particular time discount. But this problem is more complex, since there exist another large competitor (Saudi Arabia), having its own plan that can also influence the path of world oil prices. The shift of Russian policy can have an important influence on the timing of oil peak and the incentive for faster shift to renewable in the world. It is also important for oil-gas substitution. 1. Introduction Future oil supply and its composition by countries and oil types (conventional, nonconventional) plays an important financial and geopolitical role for the future economics and politics. Most of oil resources are accumulated in less developed countries, mostly in Arab 1 University of Vienna, Chair of industry, Energy and Environment, Morgenstern Pl., 1, Vienna 1090, Austria; e-mail; yury.egorov@univie.ac.at. This is a part of work on FWF project P 24991-G16. Posted for free access on the website http://bwl.univie.ac.at/ieu/home/fwf-project/ 1

world. Thus, OECD countries are oil import dependent. Hence, the question of oil supply security is an important issue. There are different views on global oil scarcity. Hubbert King was the first to mention peak oil 2 and had predicted it correctly for the USA to arrive close to 1970. However, the timing of global oil peak has been revised upwards several times. There exist some opinions that we had already observed the peak production for conventional oil in the beginning of the 21 st century. Other researchers believe that it will come sooner, others later. Peak oil can be potential driver of oil price trend even above the current level. It can also bring severe consequences if arrives unexpectedly [Robert & Lienert, 2010; Hirsch et al, 2005]. Some believe that when oil production decreases, human culture, and modern technological society will be forced to change drastically. The impact of peak oil will depend heavily on the rate of decline and the development and adoption of effective alternatives. Hirsch report states that The peaking of world oil production presents the U.S. and the world with an unprecedented risk management problem. As peaking is approached, liquid fuel prices and price volatility will increase dramatically, and, without timely mitigation, the economic, social, and political costs will be unprecedented. The optimists believe that it will come later and thus nothing can support high oil price trend today. Indeed, the reported global oil reserves has been positively updated in the recent decades (see Fig. 2). The timing of future peak oil vary across researchers from 2000 to 2060 (see Fig.3), but most authors (publications prior to 2004) forecasted it to happen between 2010 and 2020. Fig. 4 3 shows current positive trend in production and pessimistic views on peak oil. However, this source also has more optimistic visions (presented mostly by IEA). Fig. 8 shows bifurcation of the day. If we continue to consume oil at the average demand level of the last 26 years at 4.45 barrel/capita/year, we get yellow line. But if supply forecast of oil peakers is true, it will follow magenta line. By 2020, the diversion between those curves can rise to 20 mb/d. Optimists support this idea by huge discoveries of non-conventional oil. Indeed, those discoveries in Northern America (US and Canada) made the USA less dependent on oil imports. Moreover, US oil price index (WTI) is lower the one in Europe (Brent) 4. The role of geopolitics on oil price is supported by the evidence of oil price growth after some political turmoil, especially in Arab countries. For example, the recent war in Iraq (June 2014) has led to oil price jump to $107 5. 2 http://en.wikipedia.org/wiki/peak_oil 3 Source: http://www.theoildrum.com/node/10163 4 On July 1, 2014, those prices were $105.37 and $112.36 correspondingly, http://www.oil-price.net/ 5 http://www.oil-price.net/ 2

2. Oil Reserves As we see from Fig. 2, most of Arab countries had stable oil reserves between 1990 and 2009. This means, that new discoveries exactly compensated production. However, the recent estimate of reserves (see Table 1) shows that Venezuela became the leader surpassing Saudi Arabia. Canada also became a big player. However, its reserves are mostly in the form of nonconventional oil (tar sands) with much higher production cost, lower recovery rate. While the reserves of US are no high comparative to its consumption, the presence of loyal neighbor (Canada) increases their energy security. While Venezuela is a huge reserve holder, its recent policy towards USA (during Chavez and Maduro) cannot be a guarantee of secure supply to the USA. Next come OPEC countries - Saudi Arabia, Iran, Kuwait, UAE. Their oil supply was always stable after 1980s. But they have to supply also Europe and Asia, and thus cannot compensate sudden drop in oil supply, caused either by political turmoil (often in Arab countries) or by suddenly approaching peak oil. Table 1. Oil reserves for main reserve holders (IEA, 2013) Rank Country Reserves (Thousand Million Barrel) 1 Venezuela 297,57 2 Saudi Arabia 267,91 3 Canada 173,10 4 Iran 154,58 5 Kuwait 104 6 United Arab Emirates 97,8 7 Russia 80 8 Libya 48,01 9 Nigeria 37,2 10 United States 30,53 11 Kazakhstan 30 12 China 23,71 13 Qatar 25,38 14 Brazil 13,15 15 Algeria 12,2 3

16 Angola 10,47 17 Mexico 10,26 18 Ecuador 8,24 19 Azerbaijan 7 3. Russian Uncertainty The oil reserves of Russia are very important since it is the 2 nd largest producer at present. Different authors 6 provide wide range of estimations for Russian oil reserves in 2006, ranging from 60 to 200 bbrl. The high uncertainty is in Russian arctic resources, especially about the cost of production. However, even those reserves contain much more natural gas than oil. While the volume of oil reserves in Russia is officially a state secret, different western companies and organizations have provided estimates. They range from 60 to 93 TMB (Thousand Million Barrel). Pessimistic estimate of 60 is given by World energy council, and optimistic of 93 is given by Russia Oil and Gas Report (2013) and BP (2014). The most likely estimate is 80 (given by IEA). If we compare those numbers with reserves of other countries, we can see that for any of the estimates Russia occupies only 7 th position, after Venezuela, Saudi Arabia, Canada, Iran, Kuwait and UAE, but still above the USA. Its share of global reserves even for optimistic estimate of 93) is only 5.5% (according to BP, 2014). If we look at the top oil producers and exporters (BP, 2014), we see that in 2013 Russia produced 10.8 million barrels daily, below Saudi Arabia (11.5 mb/d, the first position) and above USA (10.0 mb/d, the third position). The daily oil consumption of those top producers in 2013 was 18.9 mb/d (USA), 3.3 mb/d (Russia) and 3.1 mb/d (Saudi Arabia). This means two things. First, the USA is far from self-sufficiency, importing more than 40% of its oil demand. (But it far more energy secure than EU countries). The second observation is high asymmetry between Saudi Arabia and Russia. While they are very similar in production level and share of export (close to 70%), they are very different in reserves. Russian R/P ratio is only 23.6 years, while for Saudi Arabia it is 63.2 years 7. Given that the global R/P ratio is 53.3 years, we see that Russia is stripping out of its oil resources much faster than Saudi Arabia. 6 See the Table in http://en.wikipedia.org/wiki/oil_reserves_in_russia & http://www.theoildrum.com/story/2006/2/9/211031/3684 7 Source: BP 2014 4

What can be the reason for such behavior of Russia? If Russia has secret oil reserves (than nobody has an idea about), then such behavior can be rational (because invisible R/P for Russia is then well above 23 years, one can only guess how much). But it also might happen that secrecy of oil reserves is only domestic-oriented information, for people to stay cool. Suppose that BP estimate of R/P=23 is true. Then a rational consumer should have very high discount of future to prove this rational. Although the interest rate in Russia is relatively high (but not above 10%, in 2012 discount rate was 8.25% 8 ), this may be too low to justify so fast stripping of reverses. What will Russia do in 23 years, when it will not have oil not only for export, but even for domestic consumption? Do we observe fast transition to renewable energies (including biofuels) to keep Russian transport moving in 23 years? I did not see such signs; in renewable technologies Russia is well below EU and USA. So the peak oil can come to Russia suddenly, at country level, and this can happen in the next 20 years. Now let us look at different interest groups inside Russia. After the economic reforms of 1990s Russia export composition has changed. Now Russia depends on oil as key export product. In 2011, crude and refined petroleum formed 53% of the value of Russian exports (see Fig.5). Taxes from oil export are crucial for forming of Russian budget, and oil price determines whether the budget can be with or without deficit. The GDP of Russia has been growing fast after 2000 (see Fig.6). In 2013, it has nominal value of $2118 trln. and $2556 trln. in PPP (IMF estimate). However, the major population did not enjoy the benefits from that to full extent. The most of Russian population is no longer starving (like it was after market reforms by Gaidar in 1992), when GDP in PPP was declining between 1992 and 1998 (Fig.6). But the income distribution remains highly heterogeneous (the ratio of average income of top 10% to bottom 10% was close to 15, well above the levels in EU, USA and the former USSR). The inflation rate stay at 6.5% in 2013 and was between 7 and 10% in the previous decade. 11.2% of the population lived before the poverty level in 2013 9. At the same time, many of billionaries from Russia are in the top list of Forbes 10 ; top ten among them have between $19.4 bln. and $11.6 bln. of wealth and occupy positions between #43 and #108 in the world list. It is quite clear that high oil export in Russia are mostly in the interest of those rich, who can easily leave the country when it will be stripped out of oil. It is also clear that the interest of the poor majority of Russian population is to keep more oil for future generation and to 8 Source: CIA Factbook, Russia 9 http://en.wikipedia.org/wiki/russia_economy 10 http://www.forbes.com/billionaires/#tab:overall_country:russia 5

reduce country s dependence on oil exports. If such shift will happen in Russia (and now Russian elite is already divided, especially after the war in East Ukraine since April 2014), Russia can become more rational and export less oil. This cannot be a fast process (since corruption, presently high, has also to be fought, to reduce budget spending without negative impact on the population), but if this happens, the consequences for the global oil market and peak oil can be substantial. 3.1. Assessment of Russian Oil Reserves in Arctic Region BP Statistics (2014) estimates Russian oil reserves quite modestly, at 93 bln. brl (12.7 bln. ton) or 5.5% of the global reserves in 2013. However, they probably do not account for Arctic reserves of Russia where full assessment have not been provided yet. Russian press is more optimistic about Arctic oil reserves of Russia. Recently 11 the Head of Rosneft Igor Sechin has reported about discovery of new oil field in Kara Sea with provisional name Pobeda (Victory). Rosneft thinks that the resource base of Karskij shelf is 87 bbrl. of light oil, and this is comparable to resource base of Kuwait, or OAE. If those assessments (still not recognized officially y such experts as BP) will come true, Russian oil resources will grow to 175 bln. barrels, and it will move from the current 6-7 th place to the 3 rd, just after Venezuela (295 bbrl) and Saudi Arabia (260 bbrl). There exist some western confirmation to those estimates. The report [5], written in 1988 and released in 1999, puts high weight on the potential of Kara Sea, although stresses high environmental danger and substantial costs of development. It states (Table 1) that the volume of generated oil in both South and North Kara sea ca be as high as 1218 bln. barrels. But this is not yet a resource, since only 100 bln. barrels are trapped in reservoirs. They estimate recovery factor at 20%, and thus set recoverable oil reserves at 20 bln. brl., or about 3 bln. tons. The development of those fields can generate 2 bln. barrels a day (about 1/5 of current production of Russia) for 30 years. We do not know how Rossneft estimates today the recovery rate and whether recent drilling has brought upward revision of resources. But even with estimates from [5], only Kara oil reserves can add above 20% to Russian reserves. 4. Impact on Global Oil Market and Peak Oil On one hand, we have very strong fight for the oil peak to arrive later. Indeed, there are serious reasons for it to come soon, at least for conventional oil. The consequences can be 11 See http://topwar.ru/59278-rossiya-nashla-neftyanye-arabskie-emiraty-v-karskom-more-partnery-uzhemobilizuyut-greenpeace.html (in Russian) and related article http://www.bloomberg.com/news/2014-10- 03/rosneft-ceo-speaks-on-arctic-find-with-exxon-sanctions.html 6

dramatic because substitution with renewable energies will not be ready for at least several decades. Does Russia play an important role for prolonging the arrival of peak oil? With the current daily oil supply at 80-85 mb/d, Russia supplies about 7 mb/d, or more than 8%. Suppose that it will supply only half of that, or 4%. The reduction of global supply by 4% will have very important price consequences in the short run. But even in the long run there no no fast substitution of Russian role. Saudi Arabia cannot or no willing to increase its capacity substantially, caring also about the future generations. It seems that Venezuela with its huge reserves ca do that. But will it have enough capital? And will the Western world accept such leading role for Venezuela? This will increase the power of Maduro and make Venezuela an important geopolitical player in energy market. The recent attempt of Iran to play higher geopolitical role resulted in sanction by US. Similar can happen to Venezuela if it continue to play anti-american role. That means that sudden drop in Russian export is not easy to substitute. This means that such actions will accelerate the arrival of peak oil. Apart of purely political reason to drop oil export (change of discount, caring about future generation, understanding little rationality of current policy, etc), Russian export can drop because of local peak oil for Russia. It might come in 10, 15 or 20 years, if BP estimation of R/P ratio for Russia come true. If Russia would still depend on oil export for its budget, this is likely to be an unexpected, sudden shock. The global consequences for peak oil will be similar, but it will come with some delay. 5. Conclusions Here we have started from peak oil discussions and then turned to Russian role in global oil supply. There are two key points; a) uncertainty about Russian oil reserves, b) uncertainty about timing and reason for Russia to drop substantially its oil export. The major uncertainty about Russian reserves is related to Arctic, where most of oil is not yet discovered. Estimations by different sources differ substantially. However, it is more likely that the majority of hydrocarbons there are in the form of natural gas and not oil. The second uncertainty is related to the possibility of sudden change in Russian export. In principle, a sharp decline can have substantial impact both on oil prices and the timing of peak oil. However, the events of 2015 (oil price drop from $100 to $30 per barrel) have shown no change in the output of Russian oil, despite incentives to cut it (better together with OPEC members) in order to boost the price. 7

Literature 1. Robert J., Lennert M. (2010) Two scenarios for Europe: Europe confronted with high energy prices or Europe after oil peaking - Futures, doi:10.1016/j.futures.2010.04.015 2. Hirsch, Robert L.; Bezdek, Roger; Wendling, Robert (February 2005). "Peaking Of World Oil Production: Impacts, Mitigation, & Risk Management" Science Applications International Corporation/U.S.Department of Energy, National Energy Technology Laboratory. http://www.netl.doe.gov/publications/others/pdf/oil_peaking_netl.pdf 3. Foucher S. (2013) Peak Oil Update - Final Thoughts. The Oil Drum.19 August 2013. http://www.theoildrum.com/node/10163 4. BP Statistical Review, 2014. 5. The Kara Sea: A Soviet Oil Resource for the Turn of the Century. Cxx Historical program Release 1999 Figures from: http://en.wikipedia.org/wiki/peak_oil Fig.1. Dynamics of oil production in US, USSR, Saudi Arabia and Iran in 1960-2005. 8

Fig.2. Dynamics of oil reserves in 6 countries in 1980-2009. Fig.3. Different estimations for the timing of peak oil. 9

Fig.4. Dynamics of global oil production and forecasts (pessimistic). NGPL natural gas liquids. Source: http://www.theoildrum.com/node/10163 10

Fig. 5. Composition of Russian export in 2011. Source: Harvard Atlas of Economic Complexity and http://en.wikipedia.org/wiki/russia_economy Fig.6. The dynamics of growth of Russia GDP (in PPP value) in 1992-2013. Fig.7. Forecast based on parametric fit of observed production profile. Source: Oil Drum 11

Fig.8. Peak oil forecast (based on authors predicting it before 2020, yellow) versus population based model (magenta). Source: Foucher, The Oil Drum.19 August 2013 12